The markets generally enjoy a nice low volatility environment. If investors aren’t fearful, they’re more likely to push their money into riskier assets and that, in turn, tends to drive stock prices higher.
Ever since the Fed announced its pivot in the 4th quarter of last year by forecasting three rate cuts, volatility in the equity markets has been virtually non-existent.
Since the beginning of November, the VIX has pushed above the 20 level on only one single day (and even then it was back into the teens several trading days later). That degree of market calm can be good for equity sentiment in the near-term, but it can also result in some dangerous complacency.
I came across the following chart the other day on X showing options-related activity on the VIX.
The short volatility trade is back in the full swing. This is where traders sell call options on the VIX, pocket the premium and count on them expiring worthless. With volatility as suppressed as it is right now, a lot of traders think of this as almost printing free money. As long as there’s no clear catalyst that would result in a volatility spike, many believe that there’s little short-term downside in this trade.
There’s a case to be made for why it works in today’s environment. GDP growth is still positive. Investors believe that inflation is trending lower. The expectation is that the Fed will begin cutting rates later this year. All of this combines to create a backdrop where investors believe that tail risk is minimal and the short volatility trade can be profitable.
Options dealers clearly believe that’s the case today. In fact, we’re seeing historically short volatility positioning today, a trend that has been growing for nearly four years since the end of the COVID recession. Net positioning currently is in the 1st percentile of its historical range, which means that investors are INCREDIBLY confident that significant volatility is nowhere in our immediate future.
But as is the case with almost every trade in history, it works until it doesn’t.
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